LECTURE I

Basics of Economics
By:

Amsalu B. (MSc.)

Lecturer, Department of Economics

Wolkite University

Email: [email protected]

Wolkite University, Ethiopia 1

 Introduction: Basics of Economics
 Economics is one of the most exciting disciplines in social
sciences.

 The word economy comes from the Greek word oikonomos,

which means ‘one who manages a household.

 Household must allocate its scarce resources among its

various members, taking into account each member’s
abilities, efforts, and desires.

 The subject matter of economics lies on the production,

distribution and consumption of economic goods.

2
 Cont’d
 Adam Smith generally known as the father of economics
brought out his famous book, An Inquiry into the Nature and
Causes of Wealth of Nations, in the year 1776.
 There is no universally accepted definition of economics (its
definition is controversial).
 This is because different economists defined economics
from different perspectives:
1. Wealth definition
2. Welfare definition
3. Scarcity definition
4. Growth definition
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 Cont’d
 Wealth Definition: is the study of wealth how wealth is
produced and distributed.
 Welfare Definition: is on the one side a study of the wealth;
and the other and more important side, a part of the study of
man.
 Scarcity Definition: Scarcity is the condition that arises
because wants exceeds the ability of resources to satisfy
them.
 Growth definition are improving resource allocation and
utilization systems by refining the costs and benefits analysis.

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 Cont’d
 Generally, economics is a social science which studies about
efficient allocation of scarce resources so as to attain the
maximum fulfillment of unlimited human needs.
 Allocation should be efficient and unlimited human needs.
 Economics is a science of choice, it studies;
 How people choose to use scarce or limited productive
resources to produce various commodities.
 The aim (objective) of economics is to study;
 How to satisfy the unlimited human needs up to the
maximum possible degree by allocating the resources
efficiently. 5
 Rationales of Economics (Fundamental Facts)
 The definition of economics based on the fundamental facts
that provide the foundation for the field of economics.
 Human (society’s) material wants are unlimited.
 Economic resources are limited (scarce) in availability
 1. Unlimited wants: Society's wants for material goods and
services are unlimited: Why? Because,
 Wants are multiplicative
 Wants multiply endlessly
 Wants are recurrent
 Human nature is accumulative
 Human being will borrow wants from others.
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 Cont’d
 2. Limited resources: It is not possible to produce all goods
and services needed by the society
 Limited resource + Unlimited wants = Scarcity
 Scarcity raises due to a physical condition exist where the
quantity desired of a particular resource.
 The need to balance unlimited wants with limited
resources has raised the question of efficient utilization of
scarce resources.
 To allocate economic resources efficiently the discipline
called economics has emerged

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 Scope (Branch) of Economics
 Modern economics is formed by its two major branches:
 Microeconomics: a branch of economics that studies individual
units of households, firms, and industries.
 Deals with the behavior of individual prices and quantities
(Issues at individual level).
 Macroeconomics: A branch of economic analysis concerned
with the economy as a whole and sub aggregates of the
economy.
 Both microeconomics & macroeconomics are complementary
to each other. That is, macroeconomics cannot be studied in
isolation from microeconomics. 8
Microeconomics vs Macroeconomics

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 Positive Economics Vs. Normative Economics Analysis
 Positive Economics(Economics as a science): Analysis of
how the economy operates. It is concerned with analysis of
facts and attempts to describe the world as it is.
 It develops theories and laws to explain observed economic
phenomena. It tries to answer the questions what was; what is;
or what will be?
 Normative Economics (Economics as an art): Analysis a
matter of opinion (subjective in nature) which cannot be
proved or rejected with reference to facts.
 It deals with the questions like, what ought to be? or what the
economy should be? 10
 Model Building in Economics Theory
 A model is a simplified theory or a simplified picture of what
something is like or how something works.
 A model is an abstraction of the real world.
 Economic models include function, schedule and graph.
 The fundamental objective of economics is the
establishment of valid generalizations about certain
aspects of human behavior.
 A theory is a simplified picture of reality.
 Economic theory provides the basis for economic analysis
which uses logical reasoning.

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 Methods of Studying Economic Principles
1. Inductive (Empirical) method: is the process of deriving
principles. That is; it moves from facts to theories, from
particular to general.
2. Deductive (Hypothetical) method: is the process of deriving
principles. That is; it moves it moves from theories to facts,
from general to particular.
 Which is more appropriate for developing economic
theories and in principles?
 Both are needed for the proper development of scientific
economic theories and they are complementary rather than
competitive. 12
13
 Scarcity, Choice, Opportunity Cost and PPF
 The central purpose of economic activity is the production of
goods and services to satisfy consumer‘s needs and wants.
 Scarcity: The fundamental economic problem that any human
society faces is the problem of scarcity.
 The imbalance between our wants & the means to satisfy those
wants.
 Scarcity does not mean shortage while, Shortage is a specific and
short term problem, whereas,
 scarcity is a universal and everlasting problem, but shortage is a
specific and short term problem
 Shortage is unable to get the amount they want at the prevailing's
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 Scarcity versus Choice
 If resources are scarce, then output will be limited. If output is
limited, then we cannot satisfy all of our wants. Thus, choice
must be made. Choice, in turn, implies cost.
 Economic Resources
 Resources can be classified as free and scarce (Economic
resources).
 Free resources: If the amount available to society is greater
than the amount people desire at zero price. E.g. sunshine
 Scarce resource: If the amount available to society is less
than the amount people desire at zero price.
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 Economic resources are classified into four categories
1. Labor: physical as well as mental efforts of human beings in the
production and distribution of goods and services. The reward for
labor is called wage.
2. Land: natural resources or all the free gifts of nature usable in the
production of goods and services. The reward for the services of
land is known as rent.
3. Capital: all the manufactured inputs that can be used to produce
other goods and services. The reward for the services of capital is
called interest.
4. Entrepreneurship: a special type of human talent that helps to
organize and manage other factors of productions. The reward for
entrepreneurship is called profit. 16
 Opportunity cost
 Opportunity cost is the amount or value of the next best
alternative that must be sacrificed (forgone) in order to obtain
one more unit of a product.

 The value of the next best alternative that must be sacrificed is,
therefore, the opportunity cost of the decision.
 The reason why opportunity cost increases when we produce
more of one good is that economic resources are not completely
adaptable to alternative uses (specialization effect).

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 The Production Possibilities Frontier or Curve (PPF/ PPC)
 PPF is a curve that shows the various possible combinations of
goods and services that the society can produce given its
resources and technology.
 Assumptions: The quantity as well as quality of economic
resource available is fixed.
 There are two broad classes of output to be produced over the
year.
 The economy is operating at full employment and achieving
full production.
 Technology does not change during the year.
 Some inputs are better adapted to the production of one good
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than to the production of the other (specialization).
Alternative Production Possibilities

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 Cont’d
 Efficiency: Means getting the maximum output of a good from the
resources used in production.

 Every point on a production possibilities curves is efficient.

 Inefficiency: recall that a production possibilities curves shows potential
output, not necessarily actual output.
 Example: If the economy is initially operating at point B, what is the
opportunity cost of producing one more unit of computer?
 Solution: Moving from production alternative B to C we have:

 (The economy gives up 0.2 metric tons of food per computer)

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 Law of Increasing Opportunity Cost
 The law states that as we produce more and more of a product, the
opportunity cost per unit of the additional output increases. This
makes the shape of the PPF concave to the origin.

 Economic growth: an increase in the total output level occurs when

one or both of the following conditions occur.

 An increase over time in per-capita output of material good

 Increase in the quantity or/and quality of economic resources.

 Advances in technology.

 It can be achieved in different ways, including technological

advancement and the production of new types of goods.
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 Basic Economic Questions
 Economic problems faced by an economic system due to scarcity of
resources are known as basic economic problems.
 Any human society should answer the following three basic
questions.
1. What to Produce? This problem is also known as the problem of
allocation of resources.
 Every economy must decide which goods and in what quantities
are to be produced.
 The economy must make choices such as consumption goods
versus capital goods, civil goods versus military goods, and
necessity goods versus luxury goods. 22
 Cont’d
2. How to Produce? This problem is also known as the problem of
choice of technique.

1. Labour-intensive techniques and

2. capital-intensive techniques.

 Once an economy has reached a decision regarding the types of

goods to be produced and determined their respective quantities.

3. For Whom to Produce? This problem is also known as the

problem of distribution of national product.

 It relates to how a material product is to be distributed among the

members of a society. 23
 Economic Systems
 An economic system is a set of organizational and institutional
arrangements established to answer the basic economic questions.

 Three types of economic system.

1. Traditional Economy: Production and distribution are

coordinated by custom rule.

 Technological change and innovation is constrained by

tradition

 Economic activities are considered secondary to religion and

cultural values

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 Cont’d
2. Capitalistic Economy (Capitalism)

 Free market economy system

 Resources are privately owned

 The economic activities are led by invisible hand

 All means of production are privately owned, and production takes

place at the initiative of individual private entrepreneurs who work
mainly for private profit.

 Government intervention in the economy is minimal.

 This system is also called free market economy or market system or

laissez faire.
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 Cont’d
 Self interest is the motivating factor /guiding force to carry out
economic activities

 Competition is the regulating factor of self interest

 Freedom of choice

 Government plays limited role.

 The market economy is beloved to lead to

 innovation and

 quality of products

 Public Goods, Externality, Market power are some of the

problem of this system
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 Cont’d
3. Command Economy (Socialism)

 Resources are owned by the state

 Economic activities are led by the central government

 Social welfare is a guiding factor for economic activity

 resource allocation is determined by governments.

 Command economy is also known as socialistic economy.

 The economic institutions that are engaged in production

and distribution are owned and controlled by the state.

 In the recent past, socialism has lost its popularity and most
of the socialist countries are trying free market economies.
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 Cont’d

 The role of Market and competition are eliminated by law

 Freedom of choice is curbed by what the society afford for
all.
 Innovation, Quality of product are problems of this system
4. Mixed Economy
 Real world economies fall between the extremes of market
(capitalist) economy and command (socialist) economy.
 hybrid of the Free and command economy system
 This economic system that currently Ethiopia following.

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 Decision-Making Units of an Economy
 Household: a household can be one person or more who live under
one roof and make joint financial decisions.
 Households make two decisions
 Selling of their resources, and buying of goods and services
 Firm: A firm is a production unit that uses economic resources to
produce goods and services.
 Firms also make two decisions:
 Buying of economic resources and Selling of their products.
 Government: - A government is a set of organizations that have legal
and political power to control or influence households, firms and
markets. 29
 Economic Agents Interact in Two Markets
 Product market: it is a market where goods and services are
transacted/ exchanged, That is, a market where households and
governments buy goods and services from business firms.

 Factor market (input market): it is a market where economic units

transact/exchange factors of production (inputs).

 In this market, owners of resources (households) sell their

resources to business firms and governments.

 The circular-flow diagram is a visual model of the economy

that shows how money (Birr), economic resources and goods
and services flows through markets among the decision making
units. 30
Two Circular Flow Model

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Three Circular Flow Model

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 Cont’d
 The service provided by the government goes to the households
and business firms.
 The government might also support the economy by providing
income support to the households and subsidies to the business
firms.
 At this point you might ask the source of government finance to
make the expenditures, payments and additional supports to the
firms and households.
 The main source of revenue to the government is the tax
collected from households and firms.
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 Home Doing Assignment 1
 Suppose a certain economy is confronted with making choices among the
production of industrial products(I) and agricultural products (A). The
mathematical relationship that indicates the choice problem of the
aforementioned lines of production is:
I = 64 – A2, where I and A
a) State the basic assumptions and draw the PPF of this economy?
b) Suppose the economy is currently producing 2 units of agricultural
products on its PPF. What is the opportunity cost of producing one
more unit of industrial products?
c) What is the opportunity cost of producing 55 units of capital goods
instead of 39?
d) Is it possible for this hypothetical economy to produce 4 units of
agricultural good and 50 units of industrial good? If not why? 34
 THANKS!!!

THE END OF CHAPTER ONE!!!

THANKS!!! 35